Lecture 10 - Externalities

Describe a "lemons market"

"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper, by the economist GEORGE AKERLOF which examines how the QUALITY of goods traded in a market can DEGRADE in the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind. ***When buyers cannot judge a product's quality before purchasing it, low-quality products—lemons—may drive high-quality products out of the market. This occurs when the quality of the product cannot be judged before it is purchased, and when there is asymmetric information.

What are the assumptions of the Coase theorem?

(1) property rights are clearly defined >> Essential because (parties wont negotiate with each other unless property rights are clearly defined). If parties do not negotiate, the producers/consumers will consume at their personal marginal optimal rather than the social optimal. (2) bargaining costs are small - Costs need to be low, otherwise parties will not negotiate.

Briefly, state the role of governments in regards to externalities

***Governments are thought to play a role in improving the market outcomes of externalities*** This situation is thought to occur in a free-market, and Keynsian supporters suggest government policies/restriction should be implimented to prevent this, and maximize community surplus. ****>> In other words, economists often urge governments to adopt policies that "INTERNALIZE" an externality, so that costs and benefits will affect mainly parties who choose to incur them.***

Explain the free-rider problem in the given example

- 2 stores are deciding whether to hire one guard or none. - The cost of hiriing one guard is 10€ per hour. - The benefit to each store is 8€. - Because the collective benefit, $16, is greater than the cost of hiring a guard, the optimal solution is to hire the guard. - If the stores act independently, however, they do not achieve this optimal solution.In panel a, each store acts independently and pays $10 to hire a guard on its own or does not hire a guard. If both decide to hire a guard, two guards are hired, but the benefit is still only $8 per store - In panel b, the stores split the cost of a guard if both firms agree to hire one. If only one firm wants to hire the guard, it must bear the full cost. - In each of these games, the Nash equilibrium is for neither store to hire a guard because of FREE RIDING. Each store has a dominant strategy. Regardless of what the other store does, each store is always as well off or better off not to hire a guard. >>> Because of free-riding neither is incentiviced to buy the guard, and so they forgo the benefits of having a guard. The nonoptimal outcome occurs for the same reason as in other prisoners' dilemma games: The stores don't do what is best for them collectively when they act independently

Why do firms trade their permits, once they are allocated?

- Because firms vary in their production technologies and therefore face different MAC curves. >>> For some firms, polluting is very profitable and abatement costly. They will buy permits from other firms. Firms that produce little pollution or have low costs of abatement may have excess permits, which they can sell. Trade occurs until the gains from trade are eliminated.

Discuss what happens in the given photo/example, where NO property rights exist.

- Chemical firm = tons of POLLUTION per day (makes the lake smell) - Boat rental firm = sales tourists around in the (smelly) lake. These two firms will NOT NEGOTIATE with each other unless property rights are clearly defined. If the firms do not negotiate, the chemical firm produces the output level that maximizes its profit, ignoring the effect on the boat rental firm. >> Chemical firm makes $0 if it produces nothing, $10 if it produces 1 ton, and $15 if it produces 2 tons regardless of what the boat rental firm does. Thus, the chemical company has a DOMINANT STRATEGY: It produces 2 tons. >>> Knowing that the chemical company will produce 2 tons, the boat rental firm maximizes its profit with 1 boat. Because nobody else is directly affected by this pollution, we call an outcome EFFICIENT if it MAXIMIZES the sum of the profits of the two firms. The firms maximize their joint profits at $20 when the chemical company produces 1 ton and the boat rental firm rents 1 boat. Thus, the NO-PROPERTY RIGHTS EQUILIBRIUM, with joint profits of $17, is INEFFICIENT: Too much pollution is produced.

Why do competitive markets produce more negative externalities and few positive externalities?

- Competitive firms are profit maximizing, they follow Friendman´s mantra, "the business of doing business is business" - Competitive FIRMS and CONSUMERS do not have to pay for the harms of their negative externalities, so they create excessive amounts. >>> A COMPETITIVE MARKET PRODUCES EXCESSIVE POLLUTION BECAUSE THE FIRM´S PRIVATE COST IS LESS THAN THEIR SOCIAL COST. - Similarly, because producers (and consumers) are not compensated for hte benefits of a psitive externlity, too little of such externalities is produced.

What iS the cap and trade system based on? What is the underlying theory?

- Environmental external effects arise because of missing markets (resulting from unclear defined PROPERTY RIGHTS - the right to pollute). - Cap and trade creates a market for emissions: firms buy/sell a limited number of permits to pollute (property rights)

Draw the supply and demand diagram showing the effect of a pugiouvian subsidy on positive externalities

- Externality exists in the education market as MSB>MPB, such that the service is underconsumed, and a deadweight loss, representing lost benefit to society at large (Community welfare) exists. - The pugiouvian subsidy is a command-and-control policy used by governments to lower price, and thereby indirectly increase consumption (shifting MPB outwards to MSB). 1.Subsidy = P0-P2 (EQUALS MARGINAL EXTERNAL BENEFIT) 2.The supply curve shifts to S2 and price falls from P1 to P2 3.People will now consume more, the quantity increases from Q1 to Q2. 4.The output (Q2) is social efficient: because here Social marginal cost (SMC) = Social marginal benefit (SMB)

How does the cap and trade system internlize an externality

- It internalizes the pollution externality - It does so by deciding upon an acceptable level of pollution, by deciding the toal abatement required by firms. Thereby lowers pollution. - Such that the MPC shifts towards the MSC.

What is the probelm of private provision of public goods (in regards to charity)?

- Money may not go to the areas of most critical need - Too variable - When economy is in downturn (needed the most), giving decreases

What externality occurs with open-access common property?

- The MSC of consumption is higher than the MPC of consumption (as the MSP does not include the cost to society), and thus a negative externality of consumption occurs. --> The product/good is OVERCONSUMED. - E.g. the cost of fishing in a lake, has negative consequences for greater ecosystem. E.g. overconsumption of highways results in congestion.

In the given, negative externality digram (prodution pollution), identify the cost incured by third parties at the competitive equilibrium and at the social equilibrium.

- The cost of the pollution to people who live near the factories is the area under the MCg curve (g=gunk=pollution) between zero and the quantity produced. By construction, this area is the same as the area between the MCp (private costs) and the MCs (social costs) curves. At the competitive equilibrium, total externality damage= -C-D-E-G-H At the social equilibrium, total externality damage= -C-G

Define and given 3 examples of a positive externality of consumption.

- This occurs when the consumption or production of a good causes a benefit to a third party. Examples: 1. When you consume education you get a private benefit. But there are also benefits to the rest of society. E.g you are able to educate other people and therefore they benefit as a result of your education. (positive consumption externality) 2. A farmer who grows apple trees provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey. (positive production externality) 3. If you walk to work, it will reduce congestion and pollution; this will benefit everyone else in the city.

How does a cap and trade system work? How does it increase social efficiency?

1. A central authority (usually a governmental body) sets the TOTAL LEVEL OF ABATEMENT REQUIRED. This is the total amount of pollution all firms in the indistry should reduce/abate, in effect this creates a CAP on the pollution produced by the firms. 2. Based on the abatement required, the government then creates PERMITS: The number of permits issued limits total emissions to the size of the cap. 3. The government ALLOCATES PERMITS: They can be GIVEN to the firms operating in industries emitting the pollutant (either equally distributed, or distributed according to size), or they can be AUCTIONED to polluting firms by the government. 4. The permits are TRADED: For some firms, polluting is very profitable and abatement costly. They will buy permits from other firms. Firms that produce little pollution or have low costs of abatement may have excess permits, which they can sell. Trade occurs until the gains from trade are eliminated. 5. The FIRMS SUBMIT PERMITS to government to cover their emissions: For each tonne of emissions produced, firms are required to provide one permit to the government. Ideally, government monitoring ensures that firms cannot cheat, and any firms caught violating the law are penalized with large fine >> In theory, this increases MPC to equal MSC (socially efficient output) - In theory, polluters who can reduce emissions most cheaply will do so, achieving the emission reduction at the lowest cost to society.

Why is cap and trade systems supported, especially by environmental economists?

1. A market based approach (hayek/neo-classical supporters) 2. Cost effective: least costly way to achieve a certain amount of emission redcution. 3. Behavioural incentives for actors within the system to exceed/further reduce the prescribed emission reduction level.

How is the value of non-market goods assesed?

1. Contingent valuation: Use surveys to assess the value of nonmarket resources 2. A stated preference approach - assumes respondent's statements indicate their true preferences 3. Hedonic pricing: Uses prices of market goods to infer the economic value of unpriced attributes e.g. environmental qualities 4. A revealed preference approach - uses behaviour as an indication of preferences

What are the 3 broad categories of externalities?

1. Externalities of production (positive and negative) and consumption (positive and negative). 2. public goods 3. common pool resources.

Give 2 examples of adverse selection

1. INSURANCE: People who buy life insurance policies are better informed about their own health than insurance companies are. >> If an insurance company offers to insure people against death for ten years at a FIXED RATE, a disproportionately large share of unhealthy people will buy this policy. >> Because of this adverse selection, the insurance company will pay off on more policies than it would pay if healthy and unhealthy persons bought the insurance in proportion. >> This raises the costs for the insurance firm (COSTS ARE HIGHER THAN IF THOSE SEEKING INSURANCE WERE RANDOMLY SELECTED BETWEEN HEALTHY AND UNHEALTHY). e.g. the unhealthy benefit at the cost of the insurance firm. 2. MATERNITY LEAVE: If one firm starts offering an unusually generous maternity leave to mothers of newborn children, a disproportionate number of women planning to become mothers in the near future will apply for employment with that firm. >> The intention to have children is known to potential employees but NOT to the firm. >> As a result, the COST OF THIS BENEFIT is greater to the firm than its COST WOULD BE IF THE EMPLOYEES WERE A RANDOM SAMPLE of the entire population. 3. Lemon´s market

What are the common types of "command-and-control—direct regulation"?

1. Pigouvian tax 2. Pigouvian subsidy 3. Ban 4. Quotas

What are the issues with a cap and trade system?

1. Policymakers need to set the correct total level of abatement (the cap) - not easy to determine 2. Putting a price on pollution may send the wrong signal to firms e.g. making production profitable 3. Have to keep track that firms do not excede their permitted levels. May be difficult.

What are the 2 general approaches to internalizing externalities?

1. Private solutions 2. Governments solutions

What are the ways to reduce the free rider problem? List them.

1. Social pressure 2. Privatization - exclusion - elimiates free riding. 3. Compulsion (governments makes paying for it compulsory, such as entrance fees and through taxes).

How are the firms for the 2-firm model chosen?

1. What is important is that they both add to a "COMMON POOL OF POLLUTION" - it is this pool that the government is trying to reduce/puts a cap on, by specifying the total level of abatement required. 2. Also important that the pollution distributes well in the system/ the location of the firm does not affect how much pollution it contributes to the pool. (a perfect example is CO2).

What are the 2 broad categories of government solutions to externalities?

1.) Command-and-control—direct regulation 2.)Market-based policies—provide incentives

What are the 2 responses to adverse selection? What are the problems with the two solutions?

1.) Restricting opportunistic behavior THROUGH UNIVERSAL COVERAGE (Gov. or employers provide unisal insurance or mandate insurance) ->> Thereby reduce the adverse selection that would arise from having a disporportionate number of unhealthy people paying for insurance 2.) EQUALIZING INFORMATION (e.g. screening and signalling) - UNINFORMED = SCREEN. Screening is the action taken by an uninformed person to determine the information possessed by informed people. e.g. a buyer may test drive used cars. e.g. health insurers try to know the health history of a potential costumer. >> Collecting information is COSTLY. - INFORMED = SIGNAL. Signaling is an action taken by an informed person to send information to a less-informed person. e.g. a firm may send a signal—such as widely distributing a favorable report on its product by an independent testing agency—to try to convince buyers that its product is of high quality. >> Signals solve the problem only if they are CORRECT.

Define and explain a pigouvian tax

A Pigovian tax (also spelled Pigouvian tax) is a tax on any market activity that generates NEGATIVE externalities (costs not included in the market price) of both production and consumption. The tax is intended to correct an inefficient market outcome, and does so by being set equal to the social cost of the negative externalities >> Thereby shifting the MPC up to the MSC, such that the market is at an equilibrium at the socially efficient output level.

Define pecuniary externality and give an example

A pecuniary externality occurs when the actions of an economic actor cause an increase or decrease in market prices. >> When economic actions affect a third party through market PRICES. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young people in the area to get onto the property ladder. >> In this case the marginal social cost would shift upwards, increasing price, and effecting the less wealthy like students and pensionists.

Define and explain a pigouvian subsidy

A pigouvian subsidy is a subsidy that is used to encourage behaviour that have positive effects on others who are not involved, or society at large. >> It aims to reduce the cost for consumers/producers, to shift outword MPB, such that it equals the MSB and the market exists in equilibrium.

Define public good

A public good is a product that a.) one individual can consume without reducing its availability to another individual (NON-RIVAL GOODS). All public goods lack rivalry, but only some lack exclusion (does not need to be paid for to consume)

Define abatement cost and marginal abatement cost

Abatement cost is the cost of reducing environmental negatives such as pollution. (Abate = make less intense) Marginal cost is an economic concept that measures the cost of an additional unit. >>> The marginal abatement cost (MAC), in general, measures the cost of reducing one more unit of pollution.

RECAP of government lecture. Define an ad valorem tax, draw a supply-demand diagram showing a 20% VAT tax and compare an Ad valorem tax to a specific tax.

Ad valorem, comes from Latin and literally means "according to value". Accordingly, an ad valorem tax means charging a duty, fee, or tax according to the value of goods and services, instead of by a fixed quantity (specific tax). E.g. service charge, common to have a 20% service charge. The most common is property taxes levied on real estate.

How does adverse selection lead to a market failure?

Adverse selection creates a market failure by REDUCING the size of a MARKET or ELIMINATING it, thereby PREVENTING DESIREABLE TRANSACTIONS. >>> Consumer ignorance about quality leads to a LESS EFFICIENT USE OF RESOURCES than would occur if everyone had perfect information. E.g. INSURANCE: Insurance companies have to charge higher rates for insurance due to adverse selection or choose not to offer insurance at all. >>> Very few older people, regardless of their health, buy term lifeinsurance because the rates are extremely high as a result of adverse selection. E.g. ADVERSE SELECTION: A parental leave benefit's higher cost due to adverse selection may discourage firms from offering the benefit, a decision that hurts both employees who are new parents (because they lose the benefit) and the firm (because it cannot use a benefit that would otherwise allow it to pay a lower wage).

Define adverse selection

Adverse selection: Opportunistic behaviour characterized by an informed person's benefiting from trading or otherwise contracting with a less informed person who does not know about an UNOBSERVED CHARACTERISTIC of the informed person. >> This means that the cost to the uninformed party will be greater than if the second party was RANDOMLY SELECTED.

Can also show effect of permits using simple supply and demand model

Aims to increase the cost of producing pollution (reduces supply of permits, complete inelastic supply curve) and create an incentive to reduce the quantity of pollution.

Define positive externlity

An economic activity that has a NEGTIVE SPILL OVER EFFECT on a third party. e.g. pollution

Define positive externality

An economic activity that has a POSITIVE SPILL OVER EFFECT on a third party. e.g. education

Define externality, when do they arise, and what are the 2 broad categories of externalities?

An externality occurs when an economic transaction or economic activity affects a third part, uninvolved in the transaction. >> The externality can either be positive or negative in nature. *** By-products of consumption or production that may benefit or harm third parties*** This situation is thought to occur in a free-market, and Keynsian supporters suggest government policies/restriction should be implimented to prevent this, and maximize community surplus. >> In other words, economists often urge governments to adopt policies that "INTERNALIZE" an externality, so that costs and benefits will affect mainly parties who choose to incur them.

In a barganing between two parties, what is the EFFICIENT OUTCOME defined as?

An outcome is efficient if it maximizes the sum of the profits (or utility for consumers) of the parties DIRECTLY affected by the externality.

How does the marginal abatement cost change as the total units produced by a plant increases/changes? How does the total abatement cost change as emissions change?

As you reduce the units produced and thereby the amount of emissions produced (x-axis), you have higher MACs (y-axis), e.g. the cost of reducing emission is higher. The first few emission reductions are relativly low, but as you reduce emissions the MAC become higher and higher. This means the total abatement costs get exponentially higher, as emisisons are reduced. >> On the actual 2-firm graph, the MAC increases as the number of permits used increases.

Critisicim of negative externlities

Assumed that firms do not care about their negative effects on third parties. However this is not the case for all firms, who promote CSR. They do not follow Friedmans mantra, "the business of doing business is business," but rather Carroll´s CSR pyramid (economics, legal, ethical and philanthropic) >> The debate however is whether they are actually doing this, or whether it is a front a business puts up because of the current consumer trend in "caring" about ethical business.

Discuss how asymmetric information leads to a market failure

Assymetric information leads to OPPORTUNISTIC BEHAVIOUR. >> The more-informed party may exploit the less-informed party// The more informed party benefits at the expense of the less informed party. The two major types of opportunistic behavior are adverse selection and moral hazard.

Why does a competitive market firm produce excessive pollution?

Because the firms private costs are less that its social costs. In the competitive equilibrium, the firm considers only its private costs in making decisions and ignore the harms of the pollution externality they inflict on others.

What is the benefit of the market based policy (cap and trade) vs. the command and control policies (subsidy and tax)?

Cap and trade is meant to provide the private sector with the FELXIBILITY required to reduce emissions while STIMULATING TECHNOLOGICAL INNOVATION AND ECONOMIC GROWTH.

What is the most common market based policy to internalize negative externalities of production?

Cap and trade system aka emission trading.

Define cap and trade

Cap and trade, is a government-mandated, market-based approach to controlling pollution by providing economic incentives for achieving reductions in the emissions of pollutants.

When and who was the Coase theorem developed by?

Coase 1960

Is in practice is the Coase theorem a pratical solution to externalities?

Coase's contribution is not so much a practical solution to the pollution problem as a demonstration that a lack of clearly defined property rights is the root of the externality problem.

Discuss compulsion as a means to avoid the free rider problem

Compulsion (governments makes paying for it compulsory, such as entrance fees and through taxes).

How does assigning property rights solve the commons problem?

Converting common-access property to private property removes the incentive to overuse it. In developing countries over the past century, fish farming on private land is increasingly used as common-access fisheries are depleted.

Is efficiey affected by which party recieves a property right?

Efficiency is achieved regardless of who receives the property rights.

Define excludable and non-excludable goods

Excludable goods: Must be paid for in order to consume them Non-excludable goods: Can be consumed, even if they are not paid for

How often does Coasian barganing occur?

For 3 reasons (1. high transaction costs, non-agreement and asymmetric information), Coasian bargaining is likely to occur in relatively few situations. Where bargaining cannot occur, the allocation of property rights affects the amount of pollution, but does not result in the SOCIALLY OPTIMAL MARKET EQUILIBRIUM/EFFICIENT ALLOCATION OF RESOURCES.

What is the problem with the assumption that property rights must be clearly defined? And how does this relate back to the PMC/SMC and PMB/SMB

For many bads, such as pollution, and for some goods, property rights are not clearly defined. E.g. No one has exclusive property rights to the air we breathe. >> Because of this lack of a price, a polluter's private marginal cost of production is less than the full social marginal cost.

So far we have talke about externalities relating to private goods, what is the class of externlities that do not arise from PRIVATE goods?

Free goods.

What if private solutions do not successfully internalize externlities/lead to socially efficient equilbrium?

Government steps in with government imposed solutions.

What are the 2 possible market equilibria of a lemon market with assymetric information?

IF sellers know the quality but buyers do not (ASSYMETRIC INFORMATION), this market may be inefficient: The equilibrium in this market DEPENDS WHETHER THE RESEVATION PRICE OF SELLERS OF THE BETTER QUALITY GOOD IS GREATER OR LESS THAN THE EXPECTED VALUE OF BUYERS (1,500). There are two possible equilibria: 1.) ALL CARS SELL at the average price (=EFFICIENT) >> sellers reservation price is LOWER than expected buyer price. 2.) ONLY LEMONS SELL for a price equal to the value that buyers place on lemons (=INEFFICIENT) >> sellers reservation price is HIGHER than expected buyer price.

In the given example, if Anne has rights of clean water, what happens? Can they reach an agreement?

If Anee has rights of clean water Will she agree to let go for <50? Will Fred agree to pay her >30?  Outcome: Filter added, no transfer Fred: $100 = $100 Anne: $140 = $140, Total: $240 Total welfare maximized since $130 + $90 = $220 < $240

Discuss what happens in the given photo/example, where property rights EXIST for the boat company to be FREE OF POLLUTION.

If a court or the government grants the boat rental firm the property right to be free of pollution, the firm can prevent the chemical company from dumping at all. With no pollution, the boat company rents 2 boats and makes $15. Rather than shut down, the chemical company offers to pay the boat company for the right to dump. The boat rental firm is willing to permit dumping only if it makes at least $15, and it may hold out for more. The largest "bribe" the chemical company is willing to offer for the right to dump is one that leaves it with a positive profit. One possible compensation agreement: The chemical company offers the boat rental firm $7 per ton (the exact payment outcome depends on the firms' bargaining skills) for the right to dump. If the firms agree to this deal, the chemical company's dominant strategy is to produce 1 ton, so the boat rental firm chooses to rent 1 boat. Both firms benefit. Indeed, in this equilibrium, their joint profits are maximized at $20 (therefore EFFICIENT - the firm pays for its negative pollution externality, thereby INTERNALIZING it). Because both parties benefit from a deal, they should be able to reach an agreement if transaction costs are low enough that it pays to negotiate.

Discuss the market power externality that results from asymmetric information.

If consumers (unlike sellers) do not know how prices vary across firms, firms may gain MARKET POWER and set prices above marginal cost (social optimal is whem MC=MR; there welfare is optimized). This is referred to as the IGNORANCE COST.

Discuss how bad products drive good ones out of the market in a situation of asymmetric information.

If consumers do not know the quality of a good they are considering buying, some firms may try to sell them a dud at the price of a superior good. >>> HOWEVER, knowing that the chance of buying schlock is high, consumers may be unwilling to pay much for goods of unknown quality. CONSEQUENTLY, firms that make high-quality products may not be able to sell them at prices anywhere near their cost of production. >>> In other words, bad products drive good ones out of the market. *** The market failure is that the market for a good-quality product is reduced or eliminated, even though (knowledgeable) consumers value the high-quality product at more than the cost of producing it.

Discuss the difference in information between perfect competition markets and other market structures

In a competitive market in which everyone has full information, consumers can buy whatever quality good they want at its marginal cost. >> CONSUMER SURPLUS IS MAXIMIZED, MR=MC = EFFICIENT. In contrast, when firms have information that consumers lack—when information is asymmetric—firms may sell only the lowest quality good, the price may be above marginal cost, or other problems may occur. >> CONSUMER SURPLUS IS LOWERED, and a DWL exists. MSC/MSB DOES NOT MPB/MPC

Discuss the difference private and social cots of externlities

In competitive markets, the firms´PRIVATE COSTS (cost of production ONLY, NOT including the externalities) includes its DIRECT COSTS of labor, energy, etc. but NOT the INDIRECT COSTS of the harm from the externality (the negative effects on third parties - e.g. sound, visual and environmental pollution. **PRIVATE COSTS = DIRECT COSTS (of production) The TRUE SOCIAL COSTS is the PRIVATE COSTS PLUST the INDIRECT COSTS of the harms from the externality. **SOCIAL COSTS = DIRECT COSTS (of production) + INDIRECT COSTS (of production)

Define private solutions to externalities

Instead of controlling externalities directly through emissions fees and emissions standards, the government may take an indirect approach by assigning a property right, such that the parties can bargain/negotiate with each other. ***The private solution to externalities is bargaining. The COASE THEOREM states that private bargaining will result in an efficient allocation (social optimum) of resources, assuming: (1) property rights are clearly defined and (2) bargaining costs are small

Describe briefly what the actions to internalize externalities of consumption and production, should do to the private marginal benefit and private marginal cost curves respectively.

Internalize positive externality of consumption: --policies should increase demand Internalize negative externality of production: --policies should reduce supply. Effectively shift the 2 curves such the they equalize the demand and supply curves.

What is the condition that defines the socially optimal equilibrium of a market. Relate this to when a market failure occurs.

MSC (S) = MSB (D) Market failure occurs when the above does not hold true. When MSC does NOT equal MSB, community welfare is NOT maximized, by definition leading to a market failure and deadweight loss.

Define market-based policies

Market-based policies are policies that use (MARKET FORCES, rather than direct command and control methods) markets, price, and other economic variables to provide incentives for polluters to reduce or eliminate negative environmental externalities.

What is the second broad type of government policy used to internalize externalities?

Market-based policies—provide incentives

Discuss how moral hazards lead to market failures

Moral hazards such as shirking, failure to take care, and reckless behavior reduce output or increase accidents, which are market failures that harm society.

Discuss the negative externality of ocean fishers in relation to open-access common property?

Most ocean fisheries are open-access common property. Ocean fishers look only at their private costs. In calculating these costs, fishers include the cost of boats, other equipment, a crew, and supplies. >> They do NOT include the cost that they impose on future generations by decreasing the stock of fish today, which reduces the number of fish in the sea next year. The fewer fish there are, the harder it is to catch any, so reducing the population today raises the cost of catching fish in the future. As a result, fishers do not forgo fishing now to leave fish for the future (UNSUSTAINABLE). The social cost is the private cost plus the externality cost from reduced future populations of fish.

Is a private solution always dependent on barganing?

No. Can also rely on the "greater good of individuals" E.g. why do you recycle? > In some countries it is by law, but in many the government relies on the greater good/moral of its people to take the initiate to recycle.

Is adverse selection always inefficient

No. Effificent if all products are sold to consumers that value the cars more, which may happen. However, it effects the equity/equiality in the market.

Discuss what happens in the given photo/example, where property rights EXIST for the Chemical firm to pollute.

Now suppose that the chemical company has the property right to dump in the lake (for example, by paying a pollution tax). Unless the boat rental company pays the chemical company not to pollute, the chemical company produces 2 tons, as in panel a of the table. The boat rental firm may bribe the chemical company to reduce its output so that both firms benefit. Again, the exact deal that is struck depends on their bargaining skills. Panel c of Table 18.2 shows what happens if the boat rental firm pays the chemical company $6 per ton for each ton less than 2 that it produces. The chemical company's dominant strategy is to produce 1 ton, and the boat rental firm rents 1 boat. The equilibrium is efficient as in the previous case.

Discuss the market INEFFICIENCY arising from a market with Assymetric information. (Sellers reservation price is higher the expected price)

Now suppose that the sellers of good cars place a value of v=1,750 on their cars and thus are unwilling to sell them for $1,500. As a result, the LEMONS DRIVE GOOD CARS OUT OF THE MARKET (if their price is below the reseravation price of good car sellers). Buyers realize that, at any price less than $1,750, they can buy only lemons. Consequently, in equilibrium, the 1,000 lemons sell for the expected (and actual) price of $1,000, and no good cars change hands. ** This equilibrium is INEFFICIENT because high quality cars remain in the hands of sellers who value them less than potential buyers do. Therefore the asymmetric information causes a competitive market to looseits desirable efficiency and welfare properties.

What is the main reason for why externlities occur? What is the condition that defines all (3 types of) externalities?

One common link among these three examples is that there is a DIFFERENCE (disconnect) BETWEEN THE PRIVATE BENEFITS AND COSTS AND  THE SOCIAL BENEFITS AND COSTS.

How does government regulation solve the commons problem?

Overuse of a common resource occurs because individuals do not bear the full social cost. TAX: By applying a tax or fee equal to the externality harm that each individual imposes on others, a government forces each person to internalize the externality. >>> For example, governments often charge an entrance fee to a park or a museum. However, if a government sets a fee that is less than the marginal externality harm, it reduces but does not eliminate the externality problem. RESTRICTION: Alternatively, the government can restrict access to the commons. - One typical approach is to grant access on a first-come, first-served basis. With quotas, people who arrive early gain access. *** In contrast, with taxes or fees, people who most heavily value the resource gain access.

What is the difference in the demand curve between a public good and a private good?

PRIVATE GOOD: The market demand or social marginal benefit curve for private goods is the HORIZONTAL SUM of the demand curves of each individual (in the market). PUBLIC GOOD: In contrast, the social marginal benefit of a public good is the sum of the marginal benefit to each person who CONSUMES the good (NOT NECESARILY PAYING FOR IT). Because a public good lacks rivalry, many people can get pleasure from the same unit of output. As a consequence, the social demand curve or willingness-to-pay curve for a public good is the VERTICAL of the demand curves of each individual.

Why does a negative externality of production result in a market failure?

PRIVATE MARGINAL COST< SOCIAL MARGINAL COST >>> OVERPRODUCTION Because the competitive force equalize the price and private marginal cost rather than the SOCIAL MARGINAL COST, which includes both the private costs and production and the externality damage. This means the equilibrium is at the market optimum and not the socially optimum quantity. At the socially optimal the price equalizes the SOCIAL MC (rather than the Private marginal cost). *** Welfare at the competitive equilibrium is LOWER =ABF-E (E is the external costs of pollution, deadweight loss resulting from the market equaing price with MC instead of social MC) ***Welfare at the social equilibrium is HIGHER =ABF (DWL of E is excluded because price = SOCIAL MC). WELFARE AT THE SOCIAL EQUILIBRIUM IS HIGHER, because the gain from reducing pollution from the competiitive socially optimum level more than offsets the loss to consumers and producers from the lower quantity.

RECAP of government lecture. Define a draw the supply and demand curve representing the change in a general market, when a price ceiling is imposed. What is the deadweight loss equal to?

Price ceiling: the maximum price a supplier can legally charge a consumer or buyer of a product. >>>It is a type of government policy, a government imposes with the purpose of protecting consumers. >>>To have an effect the government must set the price ceiling below the free market price. The price ceiling, reduces the equilibrium price from P-free market to P-price ceiling, which results in a shift to the right along the demand curve, and increases quantity from Q-free market, to Q-price ceiling. However at the lower price, suppliers are less willing and able to supply quantities, thus quantity supplied decreases to Q2, resulting in a situation of excess demand of Q-price ceiling to Q2. COMMUNITY SURPLUS/WELFARE LOSS: - Top traingle = loss of consumer surplus, as a lower quantitiy is now consumed (additional DWL, as the consumers that value the good must are now not neccesarily those that cosume them, a situation of first-come-first-serve arises, as the lower price no longer serves as a rationing system) - Bottom triangle = loss of producer surplus, as fewer units are produced at a lower price. > Both result as fewer units are now purchased at the lower price.

RECAP of government lecture. Define a draw the supply and demand curve representing the change in a general market, when a price floor is imposed. What is the deadweight loss equal to?

Price floor: the minimum price a supplier can legally charge a consumer or buyer of a product. >>>It is a type of government policy, a government imposes with the purpose of protecting suppliers. >>>To have an effect the government must set the minimum price above the free market price. The price floor, increases the equilibrium price from P-free market to P-price floor, which results in a shift to the left along the demand curve, and reduces quantity from Q-free market, to Q-price floor. However at the higher price, suppliers are more willing to and able to supply higher quantities, thus quantity supplied increases to Q2, resulting in a situation of excess supply of Q-price floor to Q2. (The govrenment typically has a support program which buys the extra supply, to artifically maintain price above price floor). COMMUNITY SURPLUS/WELFARE LOSS: - Top traingle = loss of consumer surplus - Bottom triangle = loss of producer surplus > Both result as fewer units are now purchased at the higher price.

Give a matrix over the 4 types of goods and provide examples of each.

Private goods have the properties of rivalry and exclusion. Free goods have the properties of non-rivalry and non-exclusion.

Discuss privitization as a means to avoid the free rider problem

Privatization—exclusion—eliminates free riding. A good that would be a public good if anyone could use it becomes a private good if access to it is restricted.

What is a popular solution to the market failure of public goods (free rider, tragedy of the commons)

Privitization. Privitization has increased sharply over the last decades, because it is more efficient.

Why is the cap and trade system considered a Quantity- and price-based policy?

Quantity = they issue permits Price = they trade until the MCA is equal for the 2 firms.

Define open-access common property

Resources to which everyone has free access and an equal right to exploit. Unlike private property, for which the owner can EXCLUDE others from using the property, open-access common property is not subject to such exclusion. (COMPARE: public goods must be non-rivalrous, but do not need to be non-excludable) For example, anyone can freely enter and enjoy urban parks such as Central Park in New York, Hyde Park in London, and the Boston Common.

Define rival and non-rival goods

Rival goods: Goods that only one person can consume at a time. The good is depletable. Non-rival goods: Goods that more than one person at a time can consume

Give 2 examples of moral hazards

SHIRK: An employee may shirk—fail to fulfill job responsibilities—if not monitored by the employer. INSURANCE: Insured people tend to take unobserved actions—engage in risky behaviors— that increase the probability of large claims against insurance companies, or they fail to take reasonable precautions that would reduce the likelihood of such claims.

Draw and explain the supply and demand graph for a positive externality of consumption.

SOCIAL BENEFIT>PRIVET BENEFIT >>> UNDERCONSUMPTION A positive externality of consumption occurs when the social marginal benefit of consumption is greater than the privat marginal benefit. As a result the good is therefore theoretically underconsumed. In the given example the competitive market equilibrium occurs when the D (aggrate marginal private benefit, represented by the demand curve) equals the supply curve, at quantity Qe-market and price-market. However, at this quantity the market is socially inefficient as MC(S)<MSB, beause the difference between the MC and MSB curve represent FOREGONE BENEFIT TO SOCIETY of the externality (=SWL). Therefore there is under-consumption of the positive externality. At the socially optimal equilibrium, MC=MSB at the higher quantity 50, and price 50. The MSB curve is greater than the MPB, at the socially optimal benefit beause the social Benefit = the private benefit plus the external benefit. Community welfare is increased (both consumer and producer welfare).

Discuss the market EFFICIENCY arising from a market with Assymetric information. (Sellers reservation price is below the expected price)

Sellers of good cars value their cars at v=1,250 which is less than the buyers' expected value of the cars, so that transactions can occur. The equilibrium in the good-car market is determined by the intersection of S1 and D* at F, where 1,000 good cars sell at 1500. Similarly, owners of lemons, who value their cars at only $750, are happy to sell them for $1,500 each. The new equilibrium in the lemons market is f. Thus, ALL CARS SELL AT THE SAME PRICE. Consequently, asymmetric information DOES NOT CAUSE AN EFFICIENCY PROBLEM, but it does have EQUITY IMPLICATIONS: Sellers of lemons benefit and sellers of good cars suffer from consumers' inability to distinguish quality (they effectivly subsidize the lemons). Consumers who buy the good cars get a bargain, and buyers of lemons are left with a sour taste in their mouths.

What are the labels of the supply and demand curves in externality diagrams and WHY?

Small change: instead of Supply say Marginal Cost (MC); instead of Demand say Marginal Benefit (MB) MC = is the aggragate private marginal cost curve, MC, which is the horizontal sum of the private maringal cost curves of the producer (e.g. each of the factories) of the consumer.

Define asymmetric information and give an example

So far we have examined situations in which all parties of a transaction are EQUALLY KNOWLEDGABLE or IGNORANT (in a competitive model = perfect competition) ***Assymetric information is the situation in which one party to a transaction knows a material fact that the other party does not*** For example, the seller knows the quality of a product and the buyer does not.

Discuss social pressure as a means to avoid the free rider problem

Sometimes, especially when the group is small, social pressure eliminates free riding. Social pressure results in at least minimal provision of some public goods. Such pressure may cause most firms at a mall to contribute "voluntarily" to a fund to hire security guards.

Discuss and draw Lemons Market (and good market) for cars with COMPLETE symmetric/equal information between buyers and sellers of the good and "bad" quality cars

Suppose that there are many potential buyers for used cars. All are willing to pay $1,000 for a lemon and $2,000 for a good used car. 1,000 owners of lemons and 1,000 owners of good cars are willing to sell. The reservation price of owners of lemons—the lowest price at which they will sell their cars—is $750. >> The equilibrium is at e, 1000 cars at 1000 dollars each. The reservation price of owners of high-quality used cars is v, which is less than $2,000. >> The equilibrium is at e, 1000 cars at 2000 dollars each.

Discuss and draw Lemons Market (and good market) for cars with INCOMPLETE but symmetric/equal information between buyers and sellers of the good and "bad" quality cars

The AMONT OF INFORMATION they have AFFECTS THE PRICE at which the cars sell. If no one can tell a lemon from a good car at the time of purchase, both types of cars sell for the same price, at demand curve D*, which is horizontal at 1500 dollars. Suppose that everyone is risk neutral and no one can identify the lemons: Buyers and sellers are EQUALLY IGNORANT A buyer has an equal chance of buying a lemon or a good car. Therefore the expected value of a used car is 1,500 (the average between the lemon and good car) Sellers of good-quality cars are implicitly subsidizing sellers of lemons.

What does the Coase theorem state,

The COASE THEOREM states that private bargaining will result in an efficient allocation of resources.

Why has the EU ETS been considered less succesful?

The EU ETS has been less successful than the US SO₂ scheme. 1. Some analysts think this is due largely to the fact that the permitted level of emissions was too high (too large a cap). 2. After the financial crisis in Europe, lower aggregate demand lowered firms' profit-maximizing emissions levels, and thereby demand for permits and their price. The price of permits fell dramatically, providing little incentive for firms to undertake abatement expenditures.

Give an example of cap and trade in Europe.

The European Union Emissions Trading Scheme (EU ETS), launched in 2005, is the largest CO₂ cap and trade scheme in the world, and now covers 11,000 polluting installations across the EU. National governments auction 57% of permits in the EU ETS, and the overall emission cap is tightened every year. Some of the auction proceeds are used to fund low-carbon energy innovation. Similar carbon trading schemes exist in other countries and regions.

In a given graph (in the 2 firm model) what is the abatement cost for the firm?

The area under the marginal abatement curve.

Draw AND explain the supply and demand curves for a negative externality of production (e.g. pollution). Why does the externality exist?

The competitive equilibrium, ec, is determined by the intersection of the market supply curve (MC) and the market demand curve (D). This occurs at quantity Q-market and price, p-market. The firms PRIVAT PRODUCER SURPLUS is the producer surplus of their PRVAITE MARGINAL COST CURVE: the area FGH, below the market price and above MC up to the competitive equilibrium quantity (105). >> IF THERE WERE NO EXTERNALITY,the competitive equilibrium MAXIMIZES COMMUNITY WELFARE (sum of producer and consumer surplus). HOWEVER, because of the pollution, the competitive equilibrium DOES NOT maximize community welfare. Firms produce too much pollution because they do not have to pay for its external harm (to 3rd parties). This is because the firms equivalent PRIVATE Marginal COSTS to price, rather than SOCIAlL marginal cost to price. The FULL COST of production is the social MC, which is the private costs plus additional externality people. Thus the height of the social MC curve, at any given quantity equals the VERTICAL sum of the private cost and cost of externality = MCs. The social MC intersects the demand curve at the SOCIALLY OPTIMAL quantity. At smaller quantities, the price, is higher than the full marginal cost. WELFARE is the sum of consumer and producer surplus, which is based on the SOCIAL MC, rather than Private MC. Welfare is MAXIMIZED where price equal SOCIAL marginal cost (NOT private marginal cost). >> At the social optimum, es, welfare equals ABF, the area between the demand curve and the MCs curve. ****Welfare is higher at the social optimum than at the competitive equilibrium because the gain from reducing pollution from the competitive to the socially opti-mal level more than offsets the loss to consumers and producers of the paper >> The externality exists because the firm is producing at a quantity too high, where the Private MC intersects demand, and therefore DOES NOT TAKE INTO ACCOUNT THE EXTERNAL COSTS TO SOCIETY, taken into account by the SOCIAL MC.

Is the distinction between moral hazard and adverse selection always clear?

The distinction between adverse selection and moral hazard—between UNOBSERVED CHARACTERISTIC and UNOBSERVED ACTION—is not always simple. A life insurance company may face unusually high risks if it insures George and Marge, who, unknown to the company, skydive. George will skydive whether or not he has life insurance. Knowing the risks of skydiving, he's more likely to buy life insurance than other, similar people are. His UNOBSERVED CHARACTERISTIC—his love of plunging toward the earth at high speed—LEADS TO ADVERSE SELECTIONS. Marge will skydive only if she has life insurance. Her UNOBSERVED ACTION is a moral hazard for the insurance company.

Define property right

The exclusive privilege to use an asset.

In a cap and trade system, what is the level of the cap/where is the cap set? How is it represented in the diagram?

The government creates permits: The number of permits issued limits total emissions to the size of the cap. The cap is set at a level that the government deems represents an appropraite level of pollution. The desired level, is shown by the LENGTH OF THE HORIZONTAL AXIS (the longer it is, the higher the level of abatement)

What is the solution to a free-ride problem?

The government makes paying for it mandatory

Explain the given 2-firm diagram

The government sets the TOTAL LEVEL OF ABATEMENT REQUIRED, this is called the CAP, AND creates PERMITS: The number of permits issued limits total emissions to the size of the cap. The government ALLOCATES PERMITS such that they are shared equally between the two firms (irrespective of their size).

Explain the 2-firm graph

The graph shows Firm B will buy permits from A: How many? How many permits will they exchange? As long as MCPA of firm B exceeds the MPCA of Firm A, both benefit by A selling permits to B. If the market is competitive, we expect trading until the MPCA is equalized across all firms (where the 2 curves intersect). >> Trade until permit price = MC of abatement (Pareto-efficient)

Explain the given 2-firm diagram

The graph shows permits split 50-50 and the possibility of gains from trading permits. Firm B has a higher MPCA. If it can buy a permit to pollute more from Firm A for a price less than its marginal cost, it will purchase the permit, rather than abate. This creates the possibility of gains from the trade in permits

Discribe the given 2-firm graph

The graph shows: The marginal private cost of abatement (MPCA) of firm A This is shown in red and measured in the USUAL way from the left-hand axis. It rises as its cost of abatement increases (the number of permits/emission). Firm A uses a relatively LOW-EMISSIONS technology to produce its product (MAC is positive).

Discribe the given 2-firm graph

The graph shows: the marginal cost of abatement (MPCA) of firm B. This is shown in blue and measured from the right-hand axis, so it rises from the right origin as B engages in more abatement. Firm B uses a more emissions-intensive technology to produce its product, and therefore its marginal cost of abatement is higher than for Firm A (steep MAC curve).

Draw a graph explaining the demand curve for public goods. Explain why public goods are under-provided.

The ice-cream store can get guard services without paying because the guard service is a public good. Acting alone, the television store hires fewer guards than are socially optimal because it ignores the positive externality provided to the ice-cream store, which the television store does not capture. >> Thus, the competitive market for guard services provides too little of this public good. >> UNDERPROVISION OF PUBLIC GOOD

Who are the main beneficiaries when a producer produces at the market equilibrium (rather than the social equilibrium), such that a negative externality exists?

The main beneficiaries from producing at the competitive output level rather than at the socially optimal level are the paper buyers, who pay $240 rather than $282 for a ton of paper. >> Their CONSUMER SURPLUS rises from A to ABCD. The corresponding change (from competitive to social equilibrium) in PRIVATE PRODUCER SURPLUS is (FGH-BCFG = -BCH, which in THIS figure is negative.

When is a market with (as)symmetric informaiton efficient?

The market equilibrium is efficient if all goods (both high and low quality) tgo to people who value them more than their original owners.

What is the object of the scheme for trading permits?

The objective of a scheme for trading permits is that the abatement should be done by the firms for which this is least costly because this saves scarce resources that can be used elsewhere.

In the case of a negative externality of production (pollution), whys is the optimal amount of pollution greater than zero?

The optimal amount of pollution is greater than zero. Even though pollution is harmful and we'd like to have none of it, we cannot wipe it out without eliminating virtually all production and consumption.

Define moral hazard

The second type of opportunistic behaviour resulting from asymmetric knowledge. Moral hazard is opportunistic behaviour characterized by an informed person's taking advantage of a less-informed person through an UNOBSERVED ACTION.

Explain the 2-firm graph

The shaded triangle shows the gains from trade created by the market for permits. P* is the permit price and is equal to the marginal cost of abatement in the economy. The green area above the red dashed line is the share of the gains from trade that Firm B receives, while the area below is Firm A's share of the gains from trade. The objective of a scheme for trading permits, namely that the abatement should be done by the firms for which this is least costly because this saves scarce resources that can be used elsewhere, is achieved. >>> The trading of permits achieves the desired level of abatement at the lowest resource cost to the economy

What is the general slope of the Marginal abatement curve for firms (in the 2 firm model) and why?

The slope of the MCA curve depends on the particular factory/plant. In general it is POSITIVE. How efficient (low-emission technology) the firms are at producing determines the slope of the MAC. The STEEPER the curve, the less efficient the firm is (emissions intensive technologies). The FLATTER the curve, the more energy effiicent (low-emisison technology) the firm is. This is usually in relation/a function of how old the factory is. The older the factory, the more likely a steep MAC curve is.

Free market economies or state-controlled economies?

The truth is somewhere in the middle.

What are the 2 main types of opportunistic behaviour?

The two major types of opportunistic behavior are adverse selection and moral hazard.

What are the 2 approaches to solving the commons problem?

There are two approaches to ameliorating the open-access commons problem. 1. The first is direct government regulation through either taxation or restriction of access. 2. The second is by clearly defining property rights.

While an asymmetric market with sellers reservation price below the expected price, does not lead to market inefficiency, discuss its others implications.

This asymmetric information situation DOES NOT CAUSE AN EFFICIENCY PROBLEM, but it does have EQUITY IMPLICATIONS: Sellers of lemons benefit and sellers of good cars suffer from consumers' inability to distinguish quality (they effectivly subsidize the lemons). Consumers who buy the good cars get a bargain, and buyers of lemons are left with a sour taste in their mouths

Is the lemons market for cars with COMPLETE symmetric information effficient? Why or why not?

This market is efficient because the cars (both lemons and good cars) go to people who value them more than their original owners.

Is the lemons market for cars with INCOMPLETE but symmetric information (symmetric IGNORANCE) effficient? Why or why not?

This market is efficient because the cars go to people who value them more than their original owners. >> All 1000 bad cars and all 1000 good cars are sold. Sellers of good-quality cars are implicitly subsidizing sellers of lemons.

When is the lemon market inefficient?

This occurs when there is a situation of assymmetric information and the RESERVATION of the higher quality good (the good car) is HIGHER than the EXPECTED PRICE (average between lemons and good quality cars). This means that the supply curve of the good cars is above the demand curve, such that none of the good cars are sold. *****This equilibrium is inefficient because high-quality cars remain in the hands of people who value them less than potential buyers do

What are the 3 reasons why barganing/Coase theorem (private solution), will not reach the efficient outcome (socially optimal)?

To achieve the efficient outcome, the two sides must bargain successfully with each other. HOWEVER, the parties may not be able to bargain successfully for at least three important reasons: 1. If transaction costs are very high, it might not pay for the two sides to meet >> For example, if a manufacturing plant pollutes the air, thousands or even millions of people may be affected. The cost of getting them all together to bargain is prohibitive. 2. If firms engage in strategic bargaining behavior, an agreement may not be reached. >> E.g. if one party says, "Give me everything I want" and will not budge, reaching an agreement may be impossible. 3. If either side lacks information about the costs or benefits of reducing pollution, a nonefficient outcome may occur, AND it is difficult to know how much to offer the other party and to reach an agreement if you do not know how the polluting activity affects the other party.

Define "internalize the externality"

To bear the cost of the harm that on inflicts on others (ot to capture the benefit that one provides to others).

Define the free rider problem

When an individual does not pay for a good because it is non-excludable E.g. National defense is an important example of a nonexclusive public good. The cost of protecting an extra person is literally zero when all people are protected (no rivalry), and no one in the country can be left unprotected (no exclusion). E.g. Clean air is also a public good without exclusion.

When is welfare maximized in externlity diagrams?

When price equals social marginal cost. In other words, when MC=MB (such that no externality is incurred to a third party)

When is the lemon market efficient?

When there is information symmtry, either complete knowledge between both parties, or complete ignorance between the parties. In these cases the market is efficient because the cars go to people who value them more than their original owners. The amount of information they have AFFECTS the PRICES at which the cars sell, but does NOT affect EFFICIENCY.

Discuss the effect of property right on income distribution of possible parties involved

Who gets the property rights affects the INCOME DISTRIBUTION. The property rights are valuable. The party with the property rights may be compensated by the other party.

In the given example, if Fred has rights to pollute, what happens? Can they reach an agreement?

Will he agree to add a filter for 50? Range of terms: $30 < $X < $50  Possible Outcome: Filter added for $40 Fred: $100 + $40 = $140 Anne: $140 - $40 = $100,  Total: $240 Total welfare still maximized! Property rights affect wealth, but not efficiency

What are the axis of the 2 firm graph showing how firms trade permits in a cap and trade system?

X axis = Total abatement required (e.g. units of CO2 abated). On the graph this is measured in number of permits. There are 2 y-axis, it is IMPORTANT you draw both: Y-axis 1 = abatement costs, firm A (€) Y-axis 2 = abatement costs, firm B (€)